In uncovering a century of muddled thinking about money by economists one is not sure whom to begin with - the Keynesians, the monetarists or the Austrians -- such is the embarrassment of riches one is confronted with, if riches is the right word to use for the wealth of illogic in all three schools.

We begin with Murray Rothbard. For those not in the know, Rothbard is the third person in the holy trinity of Austrian economics, the first two being Carl Menger and Ludwig von Mises.

In his book, America's Great Depression Rothbard writes:

"Consider a man's possible allocation of his monetary assets:

"He can (1) spend money on consumption; (2) spend on investment; (3) add to cash balance or subtract from previous cash balance. This is the sum of his alternatives… Furthermore, he allocates between the various categories on the basis of two embracing utilities: his time preferences decide his allocation between consumption and investment (between spending on present vs. future consumption); his utility of money decides how much he will keep in his cash balance. In order to invest resources in the future, he must restrict his consumption and save funds. This restricting is his savings, and so saving and investment are always equivalent.

"The two terms may be used almost interchangeably. These various individual valuations sum up to social time-preference ratios and social demand for money. If people's demand for cash balances increases, we do not call this "savings leaking into hoards"; we simply say that demand for money has increased. In the aggregate, total cash balances can only rise to the extent that the total supply of money rises, since the two are identical. But real cash balances can increase through a rise in the value of the dollar. If the value of the dollar is permitted to rise (prices are permitted to fall) without hindrance, no dislocations will be caused by this increased demand, and depressions will not be aggravated."

Now assume that I receive $1,000 as my salary. I spend $700 on my daily needs (consumption), $200 for a down payment on a house (investment) and add $100 to my previous cash balance. For the Austrians money is a means of exchange. So one supposes that in buying rice and vegetables or in paying for haircuts (consumption) I am using money and similarly that in making the down payment on a house (investment) I am again using money, for after all there is an exchange involved in all these transactions. Strangely, however, Rothbard concludes that the part of my salary that I do not use as a means of exchange ($100) is money, and the $900 which is consumption and investment is not money.

The wonderful thing about Rothbard is that he writes clearly, so the illogic shines through clearly. Milton Friedman is more convoluted, so it is more difficult to catch him out. But of course he does the same thing. He takes the money that is not spent on bonds, the money that is not spent on equities, the money that is not spent on consumer durables, the money that is not spent on anything, calls them money and then tries to relate this to GDP, which is the gross spending of money on real goods and services. Sancta simplicitas!

But still one is tempted to prefer Friedman. He constantly insists that money is an asset is an asset, so he is at least consistent, even if it only means that he is consistently wrong. For Rothbard, money is an asset is a means of exchange. Sometimes right, sometimes wrong, always muddled.

Not many Keynesians now talk directly about cash balances but there are exceptions like Paul Krugman who every few months brings up the "liquidity trap". Liquidity preference, liquidity trap, cash balances. Different names, same stupidity!

Using his wonderful illogic Rothbard defined what he called the "true money supply". From the figures available on the web site of the Ludwig von Mises Institute, I calculate that from December 2007 to June 2009, the period of the Great Recession, "true money supply" expanded by 15.7%. But isn't money supply supposed to contract during a recession? As Obelix didn't say: "These economists are crazy." They add up cash balances, which is, as we saw, something that is not spent, and expect to get money and then are surprised that money did not contract during the recession. This has happened for several recessions now but still the Austrians go on putting out figures for "true money supply", possibly in the hope that one day they will yield something different. Certainly they meet Einstein's definition of insanity: doing the same thing over and over again and expecting different results. Of course this particular fetish is not confined to the Austrians and "true money supply". During the same period M1 expanded by 20.2% and M2 by 12.8%.

Actually Rothbard's muddled argument suggests what we should do to calculate the correct money supply. We need to add demand deposits and currency and then SUBTRACT what he calls cash balances. The figure below shows the result for 2001-2010. It shows clearly the rise of money supply until 2006, the fall thereafter, especially the precipitate fall in money supply during the recession, and the steep rise in recent months.

The logic behind the graph can be read at The Riddle of Money, Finally Solved. More than pointing out the right way to calculate money, it reveals a totally different conception of money, showing that the only source of money apart from currency is credit.

The reader may wonder why Milton Friedman and Anna Schwartz were, despite their totally erroneous analysis, able to show that money supply contracted during the Great Depression. An educated guess is that, with hundreds of banks failing, people simply closed their bank deposits and kept their cash balances under their mattresses. Today, thanks to deposit insurance, people can safely leave their money in checking accounts. Besides, since alternative deposits pay close to zero interest and inflation is nearly zero, leaving cash in demand deposits is a costless exercise.